Margins likely to decline for FY18e due to poor start; downgraded to ‘Hold’; lack of catalysts for re-rating.
Revenue growth for Q1FY18 was in line with recent expectations while margins disappointed. Potential closure of a large deal should help tide over weak H2 but margins will still decline y-o-y for FY18e due to the poor start. TCS maintains leadership in digital in our view, but this is captured in valuation premium vs peers. We cut estimates and PT, D/G to Hold and prefer Infosys (Buy) which provides better valuation support and has an upcoming capital return programme.
Revenue in line, BFSI and retail stable: TCS delivered revenue growth of +5.2% y-o-y (+3.1% q-o-q, +2% in cc terms), slightly below our estimates but in line with recent consensus expectations. Volume growth was healthy at +3.5% q-o-q, but the gap vs the constant currency revenue growth implies significant pricing pressure. Despite recent commentary, Banking Financials Insurance (BFSI) and Retail verticals were stable. The company stopped disclosing revenue breakdown by service offering and reclassified vertical wise breakdown, a function of internal restructuring and industry transition. By geography, both US and UK had a tepid start with growth being led by continental Europe. Digital is now 18.9% of revenues and grew +7.6% q-o-q- (+26% y-o-y).
Margins disappoint: Margins declined a steep 230 bps q-o-q and missed estimates — 80 bps decline on the back of ` appreciation and 150 bps due to the wage hike in the quarter. We believe that this is also reflective of pricing pressure in the quarter. Client metrics were stable and while employee count reduced during the quarter, this was due to natural attrition and lower gross hiring.
Lack of catalysts for further rerating: We believe that a lack of confidence in commentary (especially on major verticals), slow start and margin pressures should imply that both constant currency growth and margin should be lower y-o-y in FY18e. With the buyback behind the company, there are no immediate catalysts. While TCS continues to lead in digital with robust execution and client metrics, this is captured in the valuation premium vs peers.
Valuation/Risks: We cut our revenue and margin forecasts resulting in an EPS cut of 3.3%/2.2%/3.1% for FY18e/19e/ 20e. Our 12M (month) price target is reduced to Rs 2,500 (vs `2,590 earlier), still based on 16x multiple (unchanged) applied to FY19e EPS. Downgrade to Hold.
Risks: Upside—Pick up in BFSI, improving deal flow and weaker `. Downside: Weak macro, visa issues and stronger `.